Ed Zimmerman chairs the Tech Group at Lowenstein Sandler LLP & is a startup & growth company lawyer. Jim Gregory is a compensation & benefits lawyer at Lowenstein Sandler LLP. Both are partners in the firm's NYC office.[1]

This article tackles a very high class problem in the venture capital and startup world: what exercise periods are most appropriate for options following termination of employment. Over the last several years, startups and growth companies have reevaluated the standard approach to exercise periods for stock options, which typically expire 90 days after departure. As startups have increasingly become far more valuable pre-IPO, the cost to exercise those options can become prohibitively expensive, and employees who leave before an acquisition or IPO may be leaving millions or even tens of millions of dollars on the table.

It has been ‘market’ to have a 90-day post-termination exercise period (PTEP) on stock options, but companies like Quora and Pinterest have, in the last three years, been shifting that practice. Many employers today, especially in tech, are considering extending beyond that standard three-month post termination exercise deadline. Typically, startups consider extending PTEP during the growth stage rather than earlier in the startup’s life.

Startups are reconsidering the extent to which stock options get better with age! Extended aging (for Hermitage wine) in these old barrels at the cellar of JL Chave in Mauves, France.

Ed Zimmerman (2017)

We – a deal lawyer and a compensation and benefits lawyer with more than 50 years of practicing law, almost evenly split between us – intend to cover in this article the current business, tax and legal issues involved as venture-backed startups and growth companies consider whether (or not) to extend PTEP.

At least 90% of the companies I have encountered over my decade in VC have a [PTEP] as follows: when an employee leaves a company (voluntary or involuntary, but not for Cause), the employee has 90 days to decide whether to exercise their vested stock options.

From our vantage point, most option plans for startups and growth companies require option holders to exercise within a three-month (or ninety-day) post-employment period. This three-month standard default rule evolved out of the incentive stock option (ISO) requirements but is not mandated for non-statutory options, also known as non-qualified stock options or “non-quals” (NSOs). Because the IRS does not require that NSOs meet the more restrictive rules applicable to ISOs, NSOs allow greater flexibility regarding PTEP. Any discussion of possible PTEP extension requires some basic understanding of stock options and, particularly, the rules governing ISOs and NSOs.

Starting Points: ISO or NSO

Many startups and growth companies grant NSOs to their employees and consultants. Plenty of others grant ISOs to their employees – we say “employees” rather than “employees and consultants” because in order to qualify as ISOs, the options must satisfy many IRS requirements and restrictions, including the requirement that ISOs only be granted to employees (and not to non-employee service providers like consultants, advisors or non-employee board members).

Because an ISO qualifies for potentially favorable tax treatment, which may benefit the employee, depriving that employee of those benefits is serious business (as the recent case against Uber makes clear),[2] even when doing so confers other benefits. As described in more detail below, by modifying an employee’s existing ISO (by, for example, extending the PTEP), an employer can “disqualify” the ISOs (which then become NSOs) and this can happen either intentionally or by accident. The well-advised employer who intentionally ‘modifies’ the ISO grant will provide stock option modification documents containing appropriate disclosures and requiring the written consent of the option holder to the proposed modification. In contrast, extending the PTEP for NSOs is far easier than for ISOs because NSOs by definition don’t need to satisfy the ISO tax requirements. Much of the discussion below focuses on employers extending the PTEP of ISOs as opposed to NSOs, but the main focus of this piece is whether the company should extend PTEP on options, regardless of whether the options are ISOs or NSOs.

In general, for an option to qualify as an ISO, the recipient or option holder must exercise the ISO no later than three months following the option holder’s termination of employment (or a longer period applicable in the case of death or disability).

If the terms of the option plan and/or the terms of the specific option grant expressly permit later exercise, options exercised after the three-month period automatically convert to NSOs. NSOs are treated differently – for tax purposes – than ISOs.

We are contemporaneously publishing a summary of the principal tax and other differences between ISOs and NSOs, along with a list of current ISO requirements (our ISO/NSO Article).

The Best Laid Plans: ISOs Don’t Always End up as ISOs

As a practical matter, in our experience, many options that venture-backed growth companies and startups grant as ISOs don’t end up qualifying for ISO tax treatment because the holder fails to meet the ISO holding period or other requirements (our ISO/NSO Article sets forth, in general terms, the ISO requirements). That failure to qualify as an ISO stems, in part, from the nature of how buyers typically acquire these startups. When startups are acquired, option holders typically exercise at the closing of the change of control and receive cash, making it impossible to meet the ISO stock holding period (the later of one year after exercise and two years after grant).

It’s also worth noting that the ISO tax rules are complicated. There are many sophisticated holders, often with access to expert advice. But in our experience, that isn’t always the case. Many holders and their advisors don’t fully understand these rules. Management team members can spend significant resources fielding questions and trying to explain complicated tax and options issues to employees who are facing very significant decisions. For example, when an NSO is exercised the “spread” (the amount by which the fair market value (FMV) of the stock exceeds the strike price) is taxed as ordinary income and is subject to withholding at the time of exercise. In contrast, when an ISO is exercised, there is no tax or withholding at exercise but the amount of the spread is treated as an “adjustment” under the alternative minimum tax[3] (AMT) and this has several consequences that are difficult to predict and can end up costing holders extra AMT taxes. This article’s scope doesn’t allow for a deeper dive into the complexities of AMT, but suffice it to say that determining whether the holder will be subject to AMT can be very tricky, especially early in the tax year or before the holder has real visibility into how her tax year will play out.

Exercise Periods

Several prominent companies have taken the lead in instituting option extension programs, extending the exercise period to periods ranging from one to seven years following a termination. Pinterest was the loudest voice in moving to a seven-year PTEP and that had a ripple effect in the Bay area. As Dan Primack wrote in Fortune in March 2015:

The principle we’re operating under is one of fairness,” explains Pinterest co-founder Evan Sharp. “If you’ve made an important contribution to Pinterest, you should be able to keep that value. And that shouldn’t just be for people with enough cash to satisfy their tax liability.

Even before Pinterest, Quora moved to a PTEP of ten-years (from the grant date) back in 2014 and was among the first (if not the first) to do so. See, for instance, the 2015 Quora post by early employee Stephen Trieu, which does a nice job of laying out some of the key issues. Under applicable tax rules, the exercise period can never extend beyond ten years[4] for ISOs. Ten years has also evolved as the default term for NSOs. Once the employer has set the initial term of the ISO, the employer cannot extend the term for ISOs and in many cases cannot extend the term for NSOs (without violating tax code section 409A, which – thankfully – is beyond the scope of this article, but for those seeking more on 409A in a startup context, here’s another article).

SPECIAL NOTE: Are Your Options Expiring -- The Problem With ten Year Options

Given the typical maximum ten year term and exercise period for outstanding options, companies mature enough to consider extending PTEP should also consider whether valued current and/or former team members are approaching the end of their ten year option exercise period. Private companies with option-holders approaching that end date, should consider whether to react by implementing employee liquidity programs or private tenders or to take some other approach. We discuss this more fully in our ISO/NSO Article, and while this doesn’t arise every day, as time to liquidity continues to lengthen, we expect to see this more often. We also expect that the deliberations around how to tackle liquidity solutions (tender offers or other liquidity programs) will take time and the execution will take even more time, so employers should review the aging of their equity incentive plans and consider their plan of attack well in advance of that tenth anniversary deadline.

In order to participate in the PTEP extension, some companies have required a minimum period of continued employment service. For example, some companies, including Square (see post), condition an extended PTEP on a minimum of two years of service. The PTEP is almost always limited to the period following a voluntary resignation or involuntary termination without cause, and often also includes the period following a termination on account of death or disability.

Why Extend PTEP

Several factors underpin the movement to extend option exercise periods, but the main drivers are improving employee recruiting and morale. Growth companies rolling out extended PTEP may well have a competitive advantage when recruiting against competing employers with short (90-day) PTEP, especially for startup veterans sophisticated in equity compensation matters.

Growth companies also recognize that changes in the capital markets have generally delayed IPOs and other liquidity events for private companies. Startups have historically used four-year vesting on option grants, which made enormous sense when that market standard coincided with the average holding period from first fundraising round to exit. But the holding period for many investors has extended[5] to beyond eight years (from first venture funding to exit). The combination of this extended period of startup illiquidity and the meaningful appetite (and capital) professional investors have to invest in tech startups and growth companies has spawned an active market for secondary transactions, including private tender offers. For instance, the Nasdaq Private Market platform (which hosts just one small slice of the market for managed secondary transactions) reported[6] that “[t]he first half of 2017 was the busiest period to date for private company liquidity programs conducted on” its platform. That same June 30 report noted that the median age of the companies using the platform for managed secondaries during that period was 8.5 years old, with a median of 300 employees, median funding of $135 million and median valuation of $1.4 billion.

This extended pre-liquidity period for startups has meant that venture-backed board rooms have devoted countless hours to discussing replenishing the equity of founders and other vested or near-vested employees. Boards have spent less time deliberating about extending exercise periods, yet we’ve seen a sharp increase in the difference between strike price and FMV at the time the exercise period will end. That growing difference between strike price and FMV at exercise creates a tax problem and a liquidity problem for the holders. Although the tax on exercise is deferred for ISOs (subject to AMT, as discussed above), ISO holders usually must still pay the exercise price. In addition, for NSOs, the spread at exercise will trigger an income tax, and unless the option holder exercises at exit/liquidity, she will not receive the cash to fund the tax liability. While some may argue this creates an incentive for retention, in many cases it means that employees will stay beyond when they should, either because they’ve become somewhat stagnant or restless in their role or the company has outgrown them. “Dash Victor, who served as project manager in charge of the option extension at Square, described this as the “vest and rest problem,” in his worthy 2016 Medium post recounting his learning from considering and implementing PTEP. Others have reported on the trend of over-retaining employees as “vesting in peace”[7] or “rest and vest.”[8] See, for instance, Julie Bort, “Inside the world of Silicon Valley's 'coasters' the millionaire engineers who get paid gobs of money and barely work,” Business Insider, August 6, 2017. Moreover, employees who drew energy from working at a 30 or 150 employee startup may chafe at working at a more mature 700 or 1,500-person organization. This was certainly a view expressed and endorsed by participants in our VentureCrushSF roundtable discussion (June 2017), as referenced in this Forbes article.

Given these considerations, extended exercise periods are especially significant for higher value, later-stage companies where departing employees often find it difficult to pay the exercise price on vested options. This contrasts with earlier stage startups that have granted options with a relatively low stock price that hasn’t dramatically increased from the exercise price. That said, we aren’t dissuading startups from rolling out extended PTEP earlier in their life cycle. For those few startups that early adopt extended PTEP, we recommend they do so with a sliding scale (meaning that PTEP duration hinges upon length of service in some important way).

Continuing to Reward Tenure: Sliding Scale PTEP

Sliding scale PTEP programs make sense to us across stages. As Andrew Parker wrote (in the Medium post we referenced above):

“I think equity compensation should be used to encourage long-term alignment of incentives between the company and employees, and I don’t feel that an employee who works at a startup for 1 year should get the same PTE treatment as an employee who works for 5 years. eShares PTE policy creates a linear sliding scale in how employees leaving between 1 to 5 years are treated, and that feels to me quite right.”

We recommend reading the eShares presentation regarding its own extension of PTEP. Here are two slides from that presentation that eShares used to illustrate an incremental extension of PTEP based on a sliding scale rather than step function:

A number of startups have cited Coinbase’s influence in using incremental PTEP, as Coinbase announced in August 2015 extending the “ exercise window from the standard 90 days to seven years for new employees who join and stay at least two years.” More recently, MixPanel also announced their shift to extended PTEP, using a five-year term for those employees with at least two years of tenure. Uber, under pressure on various fronts (including the stock option plan lawsuit referenced in end note 2 of this article), announced in May 2017 a massive rollout of incrementally extended PTEP “from 30 days up to 7 years for Uber employees with at least three years of tenure.”

Talk is Cheap: More Startups Discuss Than Implement Extended PTEP

The Andrew Parker Medium post notes a phenomenon that we have also been observing: while many startups and growth companies are considering extending PTEP, most are discussing rather than implementing PTEP:

A lot of companies are having this conversation and then choosing Choice #1 [not rolling out an extended PTEP program]. There is a great summary of why companies are ultimately not changing policy in this Quora answer by Quora employee Steven Trieu.

But we believe this was more likely a 2016 and 2017 conversation and not a 2018 or 2019 conversation, as we think more companies that attain substantial valuations will roll out extended PTEP.

It is worth noting that we also see companies address both this issue and some related issues (e.g., employees having ‘trapped’ equity value and fielding inbound interest for secondary sales of their equity) by providing broad liquidity. As Dash Victor of Square wrote (in the post noted above), a third alternative to extending PTEP is “Choose an alternate approach — e.g., net exercise, partner with a lender or tender offer.”

More and more we see and help clients with private tender offers, which are also complex transactions but can be great ways to relieve some pressure and do non-dilutive financings. Dan Primack wrote about this in Fortune in August 2014 noting that Uber had done below market tender offers to allow employees the opportunity to get liquidity rather than feeling like they’d be forever unable to unlock the value of their vested but expensive stock options.

Primack referenced Pinterest and AirBNB as examples of companies that had confronted this problem, noting (in his 2014 column cited above):

Pinterest, for example, restricts all employee stock sales on the secondary market and has not launched a tender offer for employees since October 2012. A future tender is not currently scheduled, although a spokesman says that ‘we are constantly evaluating ways for employees and former employees to get liquidity, including facilitating non-recourse loans and another secondary offering.

Once an employer has decided to implement extended PTEP, the employer can freely choose to allow for a longer PTEP on newly granted options (generally up to the maximum ten-year term[9] for ISOs and longer for NSOs) and to the extent the option holder elects not to exercise within the IRS-prescribed three-month PTEP for ISOs, any unexercised ISOs will automatically convert to NSOs. Forward-thinking executives who want to proactively address PTEP long before it becomes problematic, will begin to consider extended PTEP, likely on a sliding scale, from inception. We don’t see this discussed much in the current market, as PTEP extension discussions have largely been the province of more mature growth companies. But we expect that will change. Even for those who do not want to start with lengthy PTEP, starting by limiting all grants to NSOs will help facilitate an easier transition to lengthy PTEP down the road.

The IRS Paints “Modifying Existing Grants” With a Broad Brush

When implementing longer PTEP, not all options are created equal. The IRS has made it more complex to extend the post-termination exercise period for previously granted options issued as ISOs (as opposed to NSOs).

In general, the IRS deems the modification, extension or renewal of an ISO as a new option grant such that the options must re-satisfy the ISO requirements as of the modification date.

The IRS defines an ISO “modification” broadly. That definition includes any change in the terms of the ISO (or change in the terms of the plan pursuant to which the ISO was granted or in the terms of any other agreement governing the arrangement) that gives the optionee additional benefits under the ISO regardless of whether the optionee in fact benefits from the change in terms.

According to the IRS, any lengthening of the period during which the ISO holder may exercise (for instance, by extending PTEP) is a modification, regardless of whether the optionee in fact benefits from that extension or alternative right. So, for instance, if the employer extended PTEP on an existing ISO grant yet the optionee still exercises within the first 90 days following termination (even though the extended PTEP allows for a two-year PTEP), the option will likely be treated as an NSO due to the extended PTEP.

To continue to qualify as an ISO, the modified new option must have an exercise price not lower than the FMV of the stock subject to the option at the time of the modification, extension or renewal. The “new grant” must also meet all additional requirements that apply to ISOs generally (again, we summarize these in our ISO/NSO Article). In other words, to maintain ISO status, if the startup’s valuation has increased at all, the strike price of the ‘modified’ option grant must also be increased, even if it was initially granted years earlier.

If the modified ISO fails to meet any requirement for ISO treatment, the modified grant will automatically become an NSO. ISO holders therefore have a choice: keep the lower strike price on the newly extended PTEP option but lose ISO treatment; or keep the ISO but reset the strike price and holding period as of the time of the modification.

29 Days: Time Limits on Offers to Modify

Employers rolling out PTEP extensions often allow employees a version of that same choice: retain ISO treatment or lose the ISO treatment but extend PTEP. Under IRS rules, if the offer remains open for 30 days or more, the IRS will deem the modification to have been made – regardless of whether the employee in fact accepted the change. In other words, the employee’s rejection of extending the PTEP can still ruin her ISO treatment if the offer remains open for 30 or more days. In that instance, the IRS will treat the modification to have been made as of the date on which the employer made the initial offer to extend.

So employers typically keep an offer to change the terms of an ISO open for less than 30 days in order to avoid tripping the deemed modification rules. For example, an employer might notify employees that they have 29 days during which they may elect to extend PTEP and any employee who has not opted in during that 29 day period would automatically lose the opportunity for extended PTEP but would retain her ISO status. This offer (to retain ISO treatment or lose the ISO treatment but extend PTEP) must also include appropriate disclosures regarding the advantages and disadvantages of converting from ISO to NSO status. As discussed above, ISO treatment very often becomes moot as employees exercise and sell before the end of the required holding period anyway, which transforms their ISOs into NSOs. Nonetheless, when an employer seeks to eliminate ISO treatment, the equity incentive plan documents normally will condition that elimination on the express written consent of the ISO holders. Extending PTEP therefore entails having each impacted employee sign a conversion document agreeing to the conversion from ISO to NSO and acknowledging the change in tax treatment.

Pros and Cons of Extending PTEP

We’ve provided below some of the pros and cons which, in our experience, growth companies consider before adopting any PTEP extension program (whether for new or existing option grants). Again, Andrew Parker’s Medium post provides a good summary of high-level pros and cons. Note that Parker frames this section of his post as a recap of discussions he’s had repeatedly across different board rooms:

We (this “We” is me talking to the company management together collectively) likely have the current PTE setup: employees have 90 days to exercise their stock options PTE, after which point their ISOs expire and the options are returned to the [option plan] if left unexercised. So Choice #1 is to leave this policy in place and do nothing. This is the easiest thing to do. The company benefits from this approach: A) avoid the legal costs of changing PTE and existing employee equity agreements B) avoid the legal costs of doing ISO-to-NSO conversions for employees on day 90 post-termination of work (the sum of legal costs in (A) and (B) are very material) C) incur less dilution from the [option plan] because some options will likely return to the [option plan] in the future which can be reallocated to other future employees D) avoid the tax withholding and payroll taxes required on the delta between an NSO exercise price and the current 409[A] price of Common shares. This choice is the path of least resistance, but it is the least employee-friendly choice.

Here’s some additional information for you to consider.

Advantages

Employee Recruiting and Morale. As discussed above, potential hires – especially those who are sophisticated regarding how startups and growth companies compensate team members – find extended PTEPs compelling. Consequently, employers can use extended PTEP to signal a more employee-favorable company culture. If competitors are already extending exercise periods, then the employer may feel compelled to follow. Existing employees may feel they have “earned” what has vested and therefore believe they should be entitled to hold the options for a longer period without having to make a potentially substantial financial commitment upon a termination.

Less Pressure on Employees to Gain Liquidity. Extended PTEP frees employees from tying up significant dollars in a private company with a much longer path to liquidity than in previous economic cycles. Dash Victor, in his Medium post (referenced above), also explains the sort of black market that has evolved (and which we too have seen) in which employees find outside funding to exercise: Extended PTEP “[r]educes the number of employees using unapproved investors and loan companies to acquire the funds to exercise.” The use of unapproved third parties (as opposed to funds that work with companies to facilitate exercise) adds an undesirable level of complexity and anxiety. We have also become aware of situations in which employees have exercised or attempted to do so without disclosing that they involved a third party who now covertly owns a portion of the equity – that creates a slew of other issues, including securities law issues, breach of contract issues, tax issues, and basic trust concerns.

Potentially Less Complex. The extended PTEP may reduce stock option administration as an employee-base that feels less pressure to exercise will pose fewer questions and requests on management regarding deadlines to exercise, secondary sales to third parties, loans to facilitate financing on earlier exercise, and a topic we increasingly see from employee stockholders – whether their shares qualify under tax code section 1202 as Qualified Small Business Stock. For more on Qualified Small Business Stock (or QSBS) in a venture capital and growth company context, see Zimmerman and Silikovitz’s QSBS article. Moreover, as people transition from option holders to stockholders there are additional complexities as those holders will (or should) enter into a raft of stockholder agreements. For instance, as stockholders, the employees become party to a drag along and are entitled to vote on ‘golden parachute payments’ under tax code section 280G as well as triggering other housekeeping matters including market standoff or lock-up agreements and rights of first offer/first refusal/co-sale agreements. For more on the complexities of dealing with the approval of golden parachute payments under section 280G in a venture and growth equity context, see this article by Zimmerman, Mendelson and Silikovitz in Mealey’s Litigation Report. Some of the benefits cited above, however, will be offset by the additional tax reporting, withholding and other regulatory burdens of keeping the options outstanding for a longer period of time, as noted below.

Contractual Rather than Shareholder Entitlements. Stockholder rights and entitlements are significant and while extending PTEP seems very employee-friendly, it may also delay their conversion from option holders to stockholders in an important way that helps the employer. Delaware’s General Corporation Law (DGCL) provides numerous protections to minority stockholders, including the right to inspect books and records and to communicate with other stockholders. Management teams and boards owe fiduciary duties to their stockholders and must provide them with notices of various corporate transactions and even approvals. These rights do not apply to option holders. The rights of option holders are contractual in nature and while SEC Rule 701 requires startups and growth companies to make disclosure to option holders where the company has met the Rule 701 thresholds (generally speaking the startups we see that trigger Rule 701 are highly valued), startups and growth companies will have an easier time dealing with the rights of option holders than with the rights of stockholders. For more on SEC Rule 701, see this 2016 article by Zimmerman, Ehrenberg and Pederson Hintz in Forbes regarding the requirements and issues arising under this complex rule in the venture capital and growth company context.

Inequity Regarding Equity. There’s a strong argument that wealthy and liquid employees have an unfair advantage over less liquid employees because cash enables affluent employees to exercise at vesting. We’ve also seen an advantage for sophisticated employees and for “squeaky wheel” employees – meaning those who persist in making the request to exercise early and agree to buy the shares as restricted stock (for which they make a tax code section 83(b) election). Relieving the pressure on the need to exercise within or during the 90 days following employment means that this inequity fades, not entirely but at least a bit. For more on the implications of restricted stock and vesting under tax code section 83(b), see this 2015 article by Zimmerman and Silikovitz.

Disadvantages

Shareholder Dilution. Because employees are more likely to retain options with extended PTEP, a larger number of equity awards will remain outstanding, and that will dilute other shareholders (and option holders). Absent PTEP, many of these options would have expired 90 days after departure and would have returned to the option pool for future use. As a result, without these ‘recycled’ options, management will need to go to the board and the stockholders sooner to request expanding the existing option pool. Depending on the company’s available authorized capital stock, this need to increase the pool could trigger the need for a charter amendment, which requires significant approvals. Even absent the need for amending the charter, increasing the shares reserved for issuance under the equity plan could trigger protective provisions including, for example, investor-friendly anti-dilution provisions in the Company’s charter. In short, extended PTEP can result in more dilution, more consents and higher transaction costs. If the company is at odds with investors or board members, a request to expand the pool or amend the charter could hand investors or disgruntled board members precisely the leverage they’ve been seeking.

Unwieldy Cap Table. In addition to dilution, lengthening the option holders’ register means that the company will find itself in communication with employees who departed many years earlier, some of whom may be unhappy and some of whom may be somewhat difficult to track when it comes time to notify them of a company sale or other transaction. Fielding their inbound inquiries regarding their equity will consume management bandwidth, as CFOs and General Counsels frequently ask us questions like “a departed option holder wants to see our most recent 409A valuation report, do I have to provide that?” Management teams that don’t like long goodbyes will likely need to grin and bear these protracted discussions. For more on tax code section 409A as that deferred compensation rule pertains to valuation reports and the granting of stock options, see this article.

Unearned Gain. Former employees who continue to participate in the employer’s future growth without having to make a capital commitment or remain employed may be viewed as unjustly enriched in comparison to continuing employees or newly hired employees who remain committed to the company. We referenced above the need to facilitate or allow departures but the corollary is that some very desirable employees will wonder why they should remain at the company once fully or largely vested rather than continue to diversify their equity portfolio by working elsewhere as they wait to see how their newly extended options work out in coming years. We believe that a sliding scale PTEP extension helps resolve this issue by rewarding longer-tenured employees with increasing PTEP based on length of service.

Accounting and Tax Complexities Abound. Stock options with longer PTEP result in greater non-cash compensation expense for the employer. Also, as the sections above on “modifications” and the “29 days” issue explain, a modification of the terms or conditions of an existing ‘in-the-money’[10] option may be treated as an exchange of the original option for a new option of greater value. When that happens, the employer may incur additional compensation cost for financial accounting purposes based on any incremental value increase of the new option.

Moreover, there’s an accounting and remittance issue inherent in the ISO/NSO switch, as Stephen Trieu wrote in his 2014 Quora post referenced above:

ISOs tax benefits and consequences are largely the responsibility of the option holder. If there is a spread it is up to the option holder to remit taxes to the IRS in a timely manner. Once it becomes a NSO, any [payroll taxes on the] spread between FMV and exercise would have to be remitted at exercise by the company.

Now is a good time for us as authors to disclaim any accounting expertise as PTEP’s accounting ramifications fall outside the scope of this article.

We have also seen employees create a fair amount of confusion at exit when they sought to optimize by exercising ISOs even though the employees wouldn’t be able to hold for the requisite 12-month period after exercise. The employees did this in order to potentially avoid the withholding charges arising from NSO exercises. Tax withholding and reporting of former employees is ongoing and may require putting them back on payroll to administer. Explaining this in detail is beyond our scope here, but suffice it to say that exercising options has complicated tax treatment.

Potentially Increased Attrition. As discussed above, employees who cannot pay the exercise price for their vested options will feel less financially handcuffed to their employer once the option grant’s terms no longer compel exercise within the period immediately following a termination. Attrition may not be immediate, but as the company’s fortunes (temporarily) decline, the handcuffs are far less effective.

Large Disclosure Group. As mentioned above, when the company’s growth and option granting trigger SEC Rule 701 disclosure, the group of option holders entitled to that disclosure will be substantial – far more so than had the company stuck with the standard 90-day PTEP (which would have led former employees to drop from the option-holder list after 90 days). Moreover, as mentioned above, some of those option holders will have attenuated (at least chronologically) and, in some cases, dysfunctional relationships with the company. Employers that really don’t want that disclosure to land in the hands of a competitor are out of luck. That said, those same employers are likely out of luck on that score regardless once they trigger SEC Rule 701 (see article referenced above).

Employees Who Departed Before Extended PTEP. Companies choosing to lengthen PTEP will announce that decision at a specific point in time. Whatever time the company selects will necessarily ‘disadvantage’ employees who recently left and had their PTEP expire. These former employees are excluded because the IRS would view any attempt to revive their expired grants as a new grant. New grants can only be made under stock option plans to people rendering service to the company, rather than to people who previously worked at the company and used to hold options which have subsequently expired. Those who “just missed” the cut off may feel unfairly treated. While we believe this shouldn’t deter a management team and board intent on broadly extending PTEP, the team should definitely consider the implications, just as the team should ensure applying the new benefit in a nondiscriminatory manner.

Selectively Extending PTEP. Speaking of discriminating regarding PTEP, startups and growth companies often ask about selectively extending PTEP to this executive or that employee for one reason or another. Sometimes a particularly senior executive negotiates this on her or his way out the door in connection with a mutual release and sometimes companies want to implement this on a case-by-case basis for favored employees. We generally encourage avoiding the latter situation because it definitely creates the risk of discrimination and because it will engender the view that management inequitably favors some employees at the expense of others.

The seemingly selective use of PTEP also arises in the context of companies with overseas teams because foreign regulatory issues may preclude employers from offering extended PTEP across the whole company. Those employees unable to avail themselves of the enhanced PTEP may perceive this omission as unfair.

Work and Confusion. Finally, extending the PTEP will definitely require burdensome work for management, board approvals, expense for the company (as Andrew Parker mentioned in the passage quoted above), and the management team’s burden as team members field many, many questions. Employees will begin to look more closely at other benefits and rights they do have or feel they should have. Management team members should brace for this added expense, burden and scrutiny. Again, we don’t believe that this should deter a management team enthusiastic about extending PTEP, but we would be remiss if we neglected to mention this.

Conclusion

Even at 6,800 words, this is not intended to comprehensively review the issues involved in PTEP. While the length of this article is probably a comment on our inability to write concisely, it also testifies to the multi-faceted tax, legal and business complexities involved in extending PTEP.

END NOTES

[1] Ed Zimmerman attended Haverford College and Jim Gregory attended (and serves on the board of) Swarthmore College. This article is therefore the result of rivals working together! Also, this isn’t legal advice or tax advice and you can’t rely on it as legal or tax advice. It’s just an article, so speak to your own legal and tax advisors!

[2] A former employee has sued Uber in a class action. The suit alleges that the employee was fraudulently misled to believe that his options would qualify as ISOs when in fact they were mostly disqualified because of the ISO requirement that no more than $100,000 of ISOs can become exercisable in any single year. While many startups allow their shares to become exercisable over the course of a four-year vesting agreement, Uber has option awards that become exercisable after just six months. Normally, quicker vesting is seen as a big positive by employees and exercising options sooner can potentially result in long-term tax savings. But by designating them as “exercisable” at this point in time, regardless of whether they are actually exercised, it triggers the law that no employee is entitled to more than $100,000 of exercisable ISOs in a given year. The rest are automatically treated as NSOs. See LENZA H. MCELRATH III, et. al. vs. UBER TECHNOLOGIES, INC., N. D. California. Reported on, for instance, here by Dorothy Atkins in Law360, March 23, 2017

[3] AMT is beyond the scope of this article. In short, as the IRS has written, “The [AMT] applies to taxpayers with high economic income by setting a limit on those benefits. It helps to ensure that those taxpayers pay at least a minimum amount of tax.” (Site updated as of April 14, 2017, visited August 22, 2017).

[4] As discussed in greater detail in our ISO/NSO Article, where the option recipient holds 10% or more of the capital stock of the company granting the option, the term is limited to five-years (rather than ten) and the strike price must equal or exceed 110% of the then-current FMV. See Part (f) of the regulations defining an ISO entitled “(f) Options granted to certain stockholders.”

[5] “The following chart shows the average time to exit taken by tech companies that have exited since 2007. In 2007, it took a company 70 months from first funding round to exit via IPO and 59 months if via M&A – an 11 month gap. Since 2007, the time to exit via M&A has grown only marginally while exits via IPO have steadily increased in length. Companies exiting in 2013 YTD via IPO took 85 months and those via M&A took 54 months – a difference of 31 months.” CB Insights, November 7, 2013 blogpost.

[7] “Once their life’s work begins to feel like a job, a switch goes off in their brains. Some leave to start their next company. Others ‘vest in peace.’” Erin Griffith, “Term Sheet,” Fortune Magazine October 28, 2016.

[8]“In the show [Silicon Valley], Hooli "benches" employees who have outstayed their welcome at the company, but who are too valuable to go elsewhere. This is actually an effective tactic used by the likes of Google in real life. It's sometimes called "rest and vest," since you keep earning shares in the company even if you're not doing anything.” Matt Weinberger “13 ways HBO's 'Silicon Valley' nailed the real tech industry,” Business Insider (May 10, 2016).

[9]Note, however, that where the option recipient holds 10% or more of the capital stock of the company granting the option, the term is limited to five-years and the strike price must equal or exceed 110% of then-current FMV. See Note 4 above.

[10]An option is “in-the-money” if the strike price is below the current FMV of the underlying stock. An option is “out-of-the-money” in the reverse scenario, when the FMV has sunk below the strike price. Water metaphors also apply, as options are often described as “above water” or “under water” depending on whether the current stock price or FMV is above or below the strike price.